If the returns on your mutual fund are flat and dismal, you're not alone. With the S&P down 1.65% so far this year, everything's looking pretty drab.

But if holding a stagnant fund wasn't bad enough, you might actually get hit with a distribution before year-end on which you'll owe tax in April.

Many mutual funds will be making taxable distributions to shareholders this year, and some of them may be meaty. "We have seen some sizable estimates from companies," says Greg Carlson, a fund analyst at Morningstar. Of course, all things are subject to change between now and the time your fund actually pays that distribution at year's end, but fund companies are sending out warnings.

Some shareholders will get a bigger chunk than others. Small-cap and value funds have had a greatstretch over the last few years, and, of course, energy funds have had a recent run as well. "You'remost likely to see capital gain distributions from those types of funds," says Carlson.

So be on guard. While these distributions aren't going to make you broke, you do need to beaware that they're coming and try to plan accordingly.

Why Distribute?

Mutual funds are required by law to distribute at least 90% of their realizedcapital gains and dividend income to shareholders at the end of their fiscal year. That extra cashis taxable to you, whether you get a check in the mail or ask the fund to reinvest thosedistributions back into the fund.

What's worse, funds must make these distributions even if their returns are in the toilet. Soyou can still owe tax on a fund that's on a losing streak.

Here's why. Let's say your fund bought a stock back in 2002 for $15. The stock is up to $35and the manager decided to sell it in 2005. The upside is that he made $20 a share. The downside isthat gain is now "realized" and must be distributed to you, the shareholder, and will be taxed. The fund's overall performance, no matter how bad or how good, is irrelevant.

Mutual fund distributions have been around since the inception of funds. The problem is wehaven't seen them in a few years. That's because managers were working off built-up losses from thetech bubble. Managers who generated losses after the tech bubble burst were able to use thoselosses to wipe out any future gains. So if a manager had realized $100,000 in gains but had$150,000 in losses, the net effect was a $50,000 loss, meaning no distribution to you.

But those losses have run out. And managers have actually been sitting on a bunch of gainsfrom more bullish years like 2003 and 2004, says Joel Dickson, tax expert and a principal of theVanguard Group. So any securities sold in 2005 most likely had a fair amount of gain built in.With no losses left to offset them, those gains must now be passed on to you.

(Big note: If you hold mutual funds in a nontaxable account, like an IRA or 401(k),you have no worries. You don't pay tax on any of it until you withdraw it in retirement.)

More Money Out of Your Pocket

Any gains realized from securities held for more than one year will be taxed at thelong-term rate of 15%. Gains from securities held one year or less could be taxed as high as 35%.

The upside is that these distributions are most likely long term since there weren't really anygains to be seen in the short term -- energy and utility stocks notwithstanding.

But remember, capital gains aren't your only distributions. If your fund helddividend-producing stocks, those dividends have to be passed on to you too.

The good news is that qualified dividends are also taxed at the 15% rate. But unfortunately,not all dividends are qualified. And those that aren't are taxed at the ordinary income taxrates, which could be up to 35%.

Your manager must adhere to certain restrictions to ensure your dividends are "qualified." The biggest requirement is that the dividend-producing shares were held for more than two months.Basically, Uncle Sam doesn't want your manager, or anyone else for that matter, hopping in and out of stocks just in time for a dividend distribution.

The technical jargon says the shares must be held by the fund for more than 60 days outof the 121-day period that began 60 days before the security's ex-div date.

The same rule applies to you as a fund shareholder: You must have held the shares of the fundfor the same period of time.

"It's actually not hard to run afoul of these restrictions though," says Dickson, who pointsto portfolios that churn a lot of exchange-traded funds with many in-kind redemptions. But if managers have your after-tax returns in mind, they should make a hard effort to meet these rules.

Start Preparing

Many funds will soon start calculating their distribution amounts and post that info on theirWeb sites. So start checking in.

If you're disappointed, it might be time to reassess your fund's tax efficiency. Read the prospectus. Really read it. If your manger is concerned about your tax bill, it will bementioned there. And be sure to check out the risk and rewards section, says Duncan Richardson,chief equity investment officer at Eaton Vance and manager of its Tax-Managed Growth fund. "That'swhere the after-tax numbers are buried."

Then compare your pretax returns to the after-tax ones. "Investors need to understand howbig a drag taxes are," says Richardson. Lipper, the supplier of fund information, estimates thatinvestors lost $9.6 billion to mutual fund taxes in 2004. Not good.

Investigate your fund's history of distributions, says Alan Kahn, former chairman of theNew York State CPA estate-planning committee. While the past is no indication of the future, itcan give you a rough idea of how your managers work.

And if you love your fund but are getting hit with loads of taxes, consider moving itinto your IRA or selecting it in your 401(k). Then you won't have to worry about its taxability until you retire.

Finally, if you're looking to jump into a mutual fund soon, consider waiting until after the firm's record date for its distribution. Otherwise, you'll still receive these distributions and owe the IRS -- even though your investments have yet to yield any real returns.

It pays to refocus attention on to your mutual fund holdings for a while and try to minimize yourtax hits. The last thing you want to do is watch your tax bill rise instead of your returns.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback; click here to send her an email.

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